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Two Ways for Banks to Win With IPOs

There was a lot of back slapping at Morgan Stanley when Zynga had its market debut on Friday. But it should hold the self-congratulatory applause.

Zynga
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Zynga

Morgan Stanley scored the coveted position of lead underwriter for Zynga’s initial public offering. The offering was considered a lucrative win for the bank: it was paid more than $10 million for marketing and distributing shares of the new stock. In total, Zynga paid out $32.5 million in fees to its underwriters. They included a laundry list of other Wall Street heavyweights, too, like Goldman Sachs (which took in about $8.7 million).

So far, however, Zynga’s stock appears to be a dud. Its shares, which were initially priced at $10 each on Friday morning, fell to $9.05 by the end of trading Monday.

But there were even bigger losers before Zynga’s shares began trading: some of Morgan Stanley’s wealthiest clients. The bank’s investment management group used a collection of 11 of its mutual funds to buy into pre-offering shares of Zynga in February, when it paid $14 a share on behalf of its investor clients. In total, Morgan Stanley invested $75 million of its clients’ money to buy about 5.3 million shares of Zynga. As of Monday, its clients had lost a third of their investment, or about $25 million, on paper.

Morgan Stanley, which has been the top underwriter of hot technology initial public offerings, has often used client money to invest in pre-IPO shares. Coincidentally or not, it has often later found a way to land a role as a lead underwriter. In that position, it reaps eight-figure windfalls for the firm.

Such investments raise a question that has long been whispered about but rarely asked aloud: Should investment banks seeking underwriting roles in IPOs be allowed to invest client money in prospective corporate clients ahead of a potential deal?

“I’m sure it doesn’t hurt when you’re doing the IPO bake-off to be an investor,” said Steven N. Kaplan, a professor at the University of Chicago Booth School of Business.

Frank Partnoy, the director of the Center on Corporate and Securities Law at the University of San Diego and a longtime critic of Wall Street (and a former Morgan Stanley employee), has an even more skeptical view. “It’s another example of how the cash cow of IPOs creates corruption and self-dealing,” he said, adding that he takes “the corruption part as a given.”

He said that he was not so cynical as to believe that such investments were being directed by bankers or their chiefs, but that it represented a larger culture and ethos problem on Wall Street. “I doubt it’s orchestrated, but I think it’s endemic to large bank holding companies. From the top they think they have a Chinese wall. But it’s only three feet high.”

In fairness, pre-IPO investments are just as often a success as they are a failure. Morgan invested client money in Groupon in January at a $4.7 billion valuation. The deal was a huge win. Groupon’s market valuation is now worth $14.2 billion. And who later led Groupon’s IPO? Yep, Morgan Stanley. Its underwriting fee: $17.4 million.

Banks say that investments made on behalf of investor clients are completely separate from their investment banking divisions and would never be influenced by the prospect of IPO fees and the stream of other fees that are typically generated from the relationship developed underwriting a public offering. (The underwriting is usually just the tip of the iceberg; a successful IPO often means the lead banks get to underwrite secondary offerings and manage personal money on behalf the company’s executives.)

Mr. Kaplan acknowledged that such investments might represent a perceived conflict. “A mutual fund of a bank is only going to make the investment if they think it’s a good investment,” he said. He pointed out that investment managers were typically paid based on the performance of their funds, not on the take of the firm’s investment banking business. Still, he said, the banks “get inside information.”

He added: “This asks the whole question of whether the banks should be broken up. It’s the Glass-Steagall question,” he added, referring to the 1933 act that split investment and commercial banking and was repealed in 1999.

Privately, bankers say that while there is supposed to be a clear Chinese wall and that they do not seek to influence other parts of the firms, the fact that a big bank has the ability to make an investment either itself or by introducing a prospective client to the asset management side of their business can help build a relationship with potential corporate clients. A spokesman for Morgan Stanley declined to comment on the issue.

In January, Goldman Sachs invested $450 million of its own money and about $1 billion from its overseas clients in Facebook ahead of the company’s planned IPO, which is expected to take place in the first half of 2012. It has long been speculated that the transaction will help Goldman’s chances of being selected to underwrite the offering.

Facebook is now valued at more than $100 billion — so Goldman and its clients appear to have made money on paper. Facebook is in the final throes of deciding on underwriters for its initial public offering, and Morgan Stanley, Goldman and JPMorgan Chase are all considered contenders for the top underwriting spot. Facebook is expected to pay more than $100 million in underwriting fees.

To be fair, in every case that I have found, banks like Morgan Stanley and Goldman properly disclosed their potential conflicts to the public. In Zynga’s prospectus, there is a section that clearly states that Morgan Stanley, through its mutual funds, had a stake in the company. Similarly, Morgan Stanley’s prospectuses for its mutual funds clearly say the firm may have other relationships with the companies that it invests in.

Nonetheless, as arm’s length as such investments may be, they raise questions among investors. “The disclosures just illustrate to me that they have bulletproofed themselves from lawsuits,” Mr. Partnoy said.

In February, JPMorgan raised a $1.2 billion fund, called the J.P. Morgan Digital Growth Fund, to invest in pre-IPO shares of hot technology companies. While the idea for the fund came from the asset management division and the investment bank was not even told about it until after it became public, it was seen, perhaps unfairly, as a way for the bank to get closer to prospective corporate clients.

Representatives for Goldman Sachs and JPMorgan declined to comment.

“You could tell a positive story or you could tell a conflict story,” Mr. Kaplan said.

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